Supplemental Unemployment Benefit (SUB) Plans and COVID-19

Practical Law Article w-025-1950 (Approx. 15 pages)

Supplemental Unemployment Benefit (SUB) Plans and COVID-19

by Practical Law Employee Benefits & Executive Compensation

State-Law Unemployment Benefits Programs

Although not the focus of this Article, numerous resources are available regarding state-law unemployment insurance benefit offerings. For example, the Department of Labor (DOL) has issued FAQ guidance that includes a 50-state directory of state unemployment insurance offices.

For more information, see:

By design, benefits under an employer's SUB plan must supplement these state-law unemployment benefit programs.

Expanded Unemployment Benefits Under the CARES Act

Enacted in March 2020 in response to the US COVID-19 outbreak, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) included several provisions that expand unemployment coverage and benefits (Pub. L. No. 116-136 (2020)). The provisions are in addition to increased unemployment benefits under the Families First Coronavirus Response Act (FFCRA), which was also passed in response to the US COVID-19 outbreak (Pub. L. No. 116-127). The CARES Act provisions, some of which may affect the design features of an employer's SUB plan that existed before COVID-19, include:

The Pandemic Unemployment Assistance (PUA) Program, which:
- provides unemployment benefit payments for up to 39 weeks to unemployed workers or those unable to work due to COVID-19; and
- is retroactively available beginning January 27, 2020 and ending December 31, 2020 (see Legal Update, CARES Act Includes Key Labor and Employment Provisions: Pandemic Unemployment Assistance).
The Federal Pandemic Unemployment Compensation (PUC), under which:
- individuals who regularly qualify for unemployment benefits and those qualified for the PUA can receive an additional $600 per week for up to four months until July 31, 2020; and
- an employee may receive these additional amounts even if the benefits bring the employee above the employee's pre-unemployment earning level.
The Pandemic Emergency Compensation Program (PUEC), which provides federal funding for up to 13 weeks of additional unemployment benefits per year, available through December 31, 2020, for individuals who:
- Have exhausted all other benefits;
- have no right to regular compensation; and
- are able, available, and actively seeking work.

(See Road Map to the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).)

CARES Act Funding for States That Waive Waiting Week Periods for Unemployment Benefits

The CARES Act permits states to pay employees for their first week of regular unemployment benefits without an initial waiting week. Many states have already waived their one-week waiting periods:

Based on the states' emergency rules.
To qualify for increased funding of unemployment benefits under the FFCRA.

As a result, individuals may be paid the total amount of regular compensation for their first week of regular unemployment. Under the CARES Act, the federal government is fully funding the cost of the first week of payments through December 31, 2020. This CARES Act provision may permit employers that sponsor SUB plans to provide SUB plan benefits for an employee's first week of unemployment:

In states that have chosen to waive their waiting period requirements.
Where these payments are otherwise not allowed under IRS guidance.

Overview of SUB Plans and Trusts

SUB plans permit employer payments to an employee:

Following the employee's separation from service resulting from a reduction in force (RIF) or plant shut-down (see Reductions in Force Toolkit).
Under an arrangement designed to supplement state unemployment benefits received by the employee.

SUB plan arrangements have been the topic of extensive IRS guidance, much of it focusing on the specific design requirements under which SUB plan payments may receive favorable employment tax withholding treatment.

SUB plans emerged in the 1950s after labor unions were unable to secure a guaranteed annual wage. Using the collective bargaining process, some employers agreed instead to fund trusts intended to:

Provide second-level protection against layoffs following a RIF or plant shutdown (see United States v. Quality Stores, Inc., 572 U.S. 141, 152-53 (2014) (describing Ford Motor Company's adoption of SUB plan benefits in the 1950s)).
Supplement existing state unemployment compensation programs for laid-off employees.

Under a SUB plan, an employee lacking sufficient seniority to avoid being laid off may still have enough seniority to receive SUB payments during the layoff (Coffy v. Republic Steel Corp., 447 U.S. 191, 200, 205-6 (1980) (holding that SUB payments are perquisites of seniority to which returning veterans are entitled under the Vietnam Era Veterans' Readjustment Assistance Act of 1974 (VEVRAA))).

Benefits under a SUB plan may vary depending on:

The amount of assets in the plan's affiliated trust fund (see Requirements for SUB Trusts to Be Tax-Exempt).
The amount of state unemployment benefits available.
The length of the employee's employment after the plan's effective date.
The employee's seniority and accrued credits under the plan.
The duration of the employee's layoff.

SUB plan benefits also may be limited to a maximum period specified in the plan, regardless of whether the employee's separation from service is temporary or permanent.

Permitted Reasons to Pay SUB Plan Benefits; Sick and Accident Benefits

SUB plan benefits must be paid to an employee because of the employee's involuntary separation (whether temporary or permanent) from employment resulting directly from:

A RIF or discontinuance of a plant or operation.
Other similar conditions.

A SUB plan also may provide sick and accident benefits if these benefits are subordinate to unemployment compensation benefits under the plan.

Requirements for SUB Trusts to Be Tax-Exempt

A trust that is part of a plan established to pay SUB benefits is tax-exempt, under Section 501(c)(17) of the Internal Revenue Code (Code), if various requirements are satisfied (Pub. L. No. 86-667 (1960); 26 U.S.C. § 501(c)(17)). Under IRS guidance, these requirements include that:

The trust is:
- valid under local law;
- part of a written plan; and
- evidenced by an executed written document.
The related SUB plan is established and maintained by an employer exclusively to provide supplemental unemployment compensation benefits.
The SUB plan requires that principal and income are not used for or diverted to purposes other than providing SUB benefits (before satisfying all liabilities to the plan's covered employees).
Benefits are determined using objective standards and not exclusively in the trustees' discretion.
The SUB plan's eligibility requirements and benefit provisions do not discriminate in favor of officers, shareholders, supervisory employees, or highly compensated employees as defined under Code Section 414(q) (26 U.S.C. § 414(q)).

(26 U.S.C. § 501(c)(17).)

Regarding the last bulleted item, SUB benefits payable under the plan are not considered discriminatory if they bear a uniform relationship to the total compensation of covered employees under the plan.

For a trust to be considered tax-exempt under Code Section 501(c)(17), an employer must provide the IRS timely notice that it is seeking tax-exempt status for the trust (see IRS Form 1024, related instructions, and IRS webpage).

SUB payments also may be made from a voluntary employees' beneficiary association (VEBA) trust that is tax-exempt under Code Section 501(c)(9) (26 U.S.C. § 501(c)(9); see Legal Update, IRS Ruling Addresses Employer's Use of VEBA Assets).

Deductibility of Employer Contributions

Employer contributions to a trust fund that is independently controlled and established to provide benefits to employees who qualify under a SUB plan are:

Ordinary and necessary business expenses that are paid or incurred during the tax year in conducting the employer's business.
Deductible from gross income under Code Section 162(a), generally in the year paid to employees (26 U.S.C. § 162(a)).

Employment Tax Withholding Treatment of SUB Plan Benefits

Under general Code principles, SUB benefits are:

Taxable income to recipient-employees (see Quality Stores, 572 U.S. at 152-53).
Subject to federal income and employment tax withholding.

However, employers that adopted SUB plans in the 1950s did not want payments under these plans to be considered wages. This was because:

In many states, employees earning wages from their employers were ineligible to receive state unemployment benefits.
Loss of state unemployment benefits would counteract the point of an employer offering benefits under a SUB plan.

(See Tech. Adv. Mem. 9416003 (Apr. 22, 1994) (observing that if the IRS had determined that SUB plan benefits were wages, the supplemental benefits would have "defeated the goal of a de facto guaranteed annual wage by disqualifying employees from receiving the precise state benefits they were intended to supplement").)

In a seminal 1956 revenue ruling, the IRS recognized an administrative exemption from employment taxes for SUB payments made after an employee's involuntary separation from employment (Rev. Rul. 56-249 (1956)). The 1956 ruling did not create a comprehensive test for determining when SUB payments are not wages. Rather, the ruling described a particular plan design and determined that, based on that design, SUB payments under the plan did not constitute wages. If specified SUB plan design requirements are met, payments under the plan are not wages for FICA and FUTA withholding purposes (see Practice Note, Payroll (FICA) Taxes).

Overview of SUB Plan Design Under Revenue Ruling 56-249

The plan at issue in Revenue Ruling 56-249 included detailed design features governing eligible employees, benefit amounts, and employer contributions. Among other provisions, for example, the plan:

Was structured to supplement state system unemployment benefits payable to certain former employees.
Required employees to report and register for employment with a given state's employment service.
Reflected all of the state's unemployment compensation law requirements for limiting benefit payments to unemployed individuals available for suitable work.

Benefits under the plan were:

Payable only after an employee was unemployed for a specified number of weeks.
Paid in varying amounts and periods of time depending, for example, on the available amount of state unemployment benefits.

Employer Contributions to Plan's Fund

The plan at issue in the 1956 ruling also contained detailed requirements concerning the employer's contributions to the plan's fund, which was held and administered by independent trustees. These contributions generally included a specified amount multiplied by the total number of hours for which eligible employees received pay from the employer. However, the employer could stop making contributions once the overall fund amount attained a specified limit. Employer contributions were irrevocable and the fund's trustees held legal title to the fund's assets.

Limit on Combined SUB Pay and State Unemployment Benefits in Certain States

The arrangement also included a payable benefits cap that applied in states where SUB pay did not reduce state unemployment benefits. In these states, the SUB plan design restricted the combined total of state unemployment benefits, SUB plan benefits, and other remuneration (which was also limited under the arrangement) to the lesser of a prescribed:

Percentage of the individual's weekly pay after withholding.
Dollar amount.

Eight Key SUB Plan Features Under Revenue Ruling 56-249

In sum, the arrangement at issue in the 1956 ruling included the following eight features:

Benefits were paid only to unemployed former employees laid off by the employer.
Eligibility for benefits required employees to meet certain conditions after terminating employment (for example, reporting to and registering for employment with a state's employment service).
Benefits were paid by trustees of independent trusts.
The amount of weekly benefits paid was based on the amount of:
- weekly benefits payable under a state's unemployment benefits;
- other compensation permitted under a state's unemployment compensation laws; and
- the amount of weekly pay after withholding taxes and contributions.
The length of weekly benefits under the plan depended on the amount of trust assets and the employee's seniority.
The right to benefits did not accrue until a specified period after the employee's termination.
Plan benefits paid were not attributable to an employee rendering particular services while still employed.
No employee had any right, title, or interest in or to the plan fund's assets or related employer contributions until the employee was eligible to receive plan benefits.

The administrative exemption under the 1956 ruling applied:

Only if SUB payments were:
- designed to supplement an employee's receipt of state unemployment compensation; and
- actually tied to the receipt of state unemployment benefits.
In three situations where an employee was ineligible to receive state unemployment benefits, specifically, where the employee:
- did not have enough employment to be covered under the state system;
- had exhausted the period for which state unemployment benefits were available; or
- did not meet the requisite waiting period under state law (Rev. Rul. 90-72 (1990); Priv. Ltr. Rul. 201201003 (2012)).

Further IRS Guidance Expands Initial Ruling In Limited Ways

After the IRS's 1956 ruling, the IRS expanded its administrative exemption in limited ways in addressing arrangements that were substantially similar to the plan at issue in the 1956 ruling. Relatively minor variations in design (for example, the absence of a single element under the 1956 ruling) did not necessarily require a different outcome regarding the withholding treatment.

In a 1958 ruling, for example, the IRS concluded that its 1956 ruling applied to supplemental unemployment benefit plans that were similar in all material respects under the 1956 ruling, except that they were:

Unilaterally instituted by the employer.
Not union negotiated.

(Rev. Rul. 58-128 (1958).)

Under a 1960 ruling, the IRS addressed an arrangement that was materially similar to the plan in the 1956 ruling, except:

The employer made SUB payments directly to eligible former employees.
There was no trust account for holding accumulated funds.

The IRS concluded that benefits paid under this arrangement were not wages for employment tax purposes (Rev. Rul. 60-330 (1960)).

In a 1980 ruling, however, the IRS addressed the treatment of preretirement leave benefits that were:

Provided during periodic slack seasons, even if there had been no layoff.
Guaranteed as of when an employee's leave was scheduled.

Citing the requirement that SUB plan benefits be paid only for involuntary layoffs, the IRS concluded that benefits under the preretirement leave arrangement were:

Wages subject to employment tax withholding.
Not supplemental unemployment compensation benefits under the 1956 ruling.

(Rev. Rul. 80-124 (1980).)

Code Provision Addresses Income Tax Withholding

Tax reform legislation enacted in 1969 added a Code provision that required federal income tax withholding on any supplemental unemployment compensation benefit paid to an individual, regardless of whether the benefit would otherwise be considered wages (26 U.S.C. § 3402(o); see CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008) (addressing Section 3402(o) in the context of an employment tax withholding dispute involving a railroad employer's SUB plan benefit payments)). Code Section 3402 defines "supplemental unemployment compensation benefits" as amounts paid to an employee under an employer's plan because of the employee's involuntary separation from employment (whether temporary or permanent) resulting directly from a RIF, discontinuance of a plant or operation, or other similar conditions, but only if these benefits are includible in the employee's gross income.

1990 IRS Ruling Prohibits Lump-Sum Benefits

In a 1990 ruling, the IRS continued to recognize a wage exclusion for SUB pay but with certain changes (Rev. Rul. 90-72 (1990); see CSX Corp., 518 F.3d at 1334). Under Revenue Ruling 90-72:

SUB payments are excluded from wages for FICA and FUTA purposes only if they are actually linked to the receipt of state unemployment compensation, meaning that:
- the plan's design and purpose are to supplement the receipt of state unemployment compensation; and
- the payments are consistent with this purpose.
Lump-sum payments are not linked to state unemployment compensation (because the benefit amount was the same regardless of how long an individual remained unemployed).

Plan Design Under 1990 Ruling

The IRS's 1990 ruling addressed the tax treatment of six different plans. For example, an employer established one of the plans in the ruling to provide weekly benefits to former employees involuntarily separated from service due to a plant closing, layoff, or RIF. Benefits under the plan were:

Designed to supplement the receipt of state unemployment compensation.
Not attributable to an employee rendering any particular services.
Not payable in lump-sum form.

The employer funded its plan obligations using a SUB trust that was qualified under Code Section 501(c)(17) (see Requirements for SUB Trusts to Be Tax-Exempt). The duration of plan benefits depended, among other reasons, on the fund level and the employee's seniority. To be eligible for plan benefits, a former employee needed to satisfy specified conditions after the employee's temporary or permanent separation. Subject to limited exceptions, the arrangement also required laid-off or former employees to be unemployed and satisfy the requirements for receiving state unemployment compensation benefits. Under the exceptions, a former employee could still receive plan benefits if the employee was ineligible under state law for unemployment compensation because the employee:

Had insufficient wage credits or failed to satisfy the required waiting period.
Exhausted the duration of unemployment benefits.

Even if one of the exceptions applied, however, an employee still needed to be eligible for state unemployment compensation benefits.

The IRS concluded in the 1990 ruling that benefits paid under the plan were:

Structured to supplement the receipt of state unemployment compensation.
Not wages for FICA and FUTA purposes.

In contrast, another plan addressed in the 1990 ruling was similar to the one described above except that benefits were paid under the plan during the unemployment period in lump-sum form rather than as periodic payments. The IRS concluded that payments under this plan were wages for FICA and FUTA purposes because benefits paid in lump-sum form were not linked to state unemployment compensation under the SUB pay exception.

SUB Plan Payments Under Insured Arrangements

In 2012 guidance, the IRS address an arrangement under which an employer paid premiums under an insurance plan that provided benefits to employees to supplement their state-law unemployment benefits (Priv. Ltr. Rul. 201201003 (Jan. 1. 2012)). Among other plan design features, benefits under the insured arrangement were only available to individuals involuntarily unemployed from full-time employment. Benefits under the plan:

Were paid periodically and began after an individual had received unemployment benefits for two weeks.
Ended when the state unemployment benefits terminated or after 24 weeks of payments under the plan (whichever occurred first).

The IRS ruled that this arrangement was a SUB plan because it was materially similar to the plan in the IRS's 1956 ruling because, for example:

The plan was designed to supplement state unemployment benefits.
Plan benefits were linked to the receipt of state unemployment compensation.

As a result, the benefits were:

Not subject to FICA or FUTA taxes.
Subject to income tax withholding to the extent that they were includible in employees' gross income under Code Section 3402(o) (see Code Provision Addresses Income Tax Withholding).

Treatment of Short Week Benefits

In a 2003 ruling, the IRS addressed the federal employment tax consequences of a plan that paid:

Regular benefits on account of layoffs and resulting from receipt of state unemployment compensation.
Automatic short week benefits.

(Priv. Ltr. Rul. 200322012 (May 30, 2003)).

The automatic short week benefits were payable to employees with at least one year of service. Employees were eligible for automatic short week benefit payments if they worked less than a full work week, but worked at least part of the week (or were compensated for certain other specified reasons). To receive the automatic short week benefits, an employee was required to be "on layoff" as defined in the plan.

The automatic short week benefits were payable to employees either:

In partial weeks that immediately followed full weeks in which regular benefits were paid.
To make up for lost hours in weeks that did not immediately precede or follow a week in which regular benefits were paid.

The IRS concluded that regular benefits paid under the plan were not wages for FICA and FUTA purposes. The IRS also concluded that automatic short week benefits were not wages for FICA and FUTA purposes when made to individuals otherwise qualified for excludable regular benefits. Specifically, this ruling applied to automatic short week benefits that immediately preceded or followed a week in which an employee received regular benefits.

By contrast, all other automatic short week benefits were wages for FICA and FUTA purposes. This ruling governed automatic short week benefits to make up for lost hours in weeks that did not immediately precede or follow a week in which regular benefits were paid (presumably because these payments did not satisfy the requirement of being specifically designed to supplement state unemployment benefits).

2014 Supreme Court Ruling on Severance Payments and FICA (Quality Stores)

In 2014, the Supreme Court held that severance payments are taxable wages for FICA purposes (United States v. Quality Stores, Inc., 572 U.S. 141 (2014); see Legal Update, Supreme Court Holds That Severance Payments Are Subject to FICA and Severance Benefits, Plans, and Agreements Toolkit). In reaching this decision, the Court addressed the history of SUB payments and emphasized:

The broad definition of "wages" for FICA purposes.
That severance payments to terminated employees are clearly remuneration for employment under this definition.

The Court observed that the IRS continued to recognize that severance payments tied to the receipt of state unemployment benefits are exempt from employment tax withholding (under guidance that was not directly at issue in the Quality Stores litigation).

Although the severance payments in Quality Stores were not linked to state unemployment benefits, the Court appeared to question (though it did not directly address) whether the IRS's exemption for SUB plans was consistent with the broad FICA definition of wages.

Proposed Rules Address Post-TCJA UBTI Calculations for SUBs

The Code provides a tax exemption for trusts that are used to pay supplemental unemployment compensation benefits (26 U.S.C. § 501(c)(17); see Requirements for SUB Trusts to Be Tax-Exempt). This provision defines supplemental unemployment compensation benefits to include benefits paid to employees sustaining an involuntary separation from employment (whether temporary or permanent) due to a RIF, discontinuance of plant or operation, or similar conditions. In addition to unemployment benefits, tax-free status is available for trusts that fund payments for losses of employment due to sickness or accident.

In April 2020, the IRS issued proposed regulations addressing how certain tax-exempt organizations, including SUB trusts, determine:

If they have more than one unrelated trade or business.
If so, how these organizations calculate their unrelated business taxable income (UBTI) (85 Fed. Reg. 23172 (Apr. 24, 2020)).

2017 Tax Reform Changed Rules for Determining UBTI

Under the Code, certain organizations that are exempt from federal income taxation (for example, trusts affiliated with a SUB plan) are still subject to tax on their UBTI. UBTI is generally defined as income from unrelated trade or business that is regularly carried on by the entity, less certain deductions (26 U.S.C. § 512(a)(1)). A trade or business is unrelated if conducting the business is not substantially related to an exempt entity's performance of the charitable, educational, or other purpose that is the basis for its tax-exempt status.

Under a special definition of UBTI that applies to SUB trusts, UBTI is generally defined as income from an unrelated trade or business that is regularly carried on by the entity, but excluding exempt function income. Exempt function income consists of:

Member income, which includes member-paid dues, fees, or similar amounts.
Passive income, which includes investment income that is set aside for charitable gift purposes, paying benefits, or related administrative purposes.

The Code limits the amounts that SUB trusts may set aside under the exempt function income rules (26 U.S.C. § 512(a)(3)(E)).

Before 2018, organizations with more than one unrelated trade or business could aggregate the incomes from those trades or businesses and deductions in calculating UBTI. In late 2017, however, the Tax Cuts and Jobs Act (TCJA) added a Code provision requiring that UBTI be calculated separately for each trade or business (known as "silos") (26 U.S.C. § 512(a)(6); see Tax Cuts and Jobs Act (TCJA) Compliance for Fringe Benefits and Health Plans Toolkit). As a result, a deduction from one trade or business for a year cannot be used to offset income from a different unrelated trade or business for the same year.

Proposed Rules Address Post-TCJA Calculations of UBTI

Consistent with the TCJA, the proposed regulations require organizations with more than one unrelated trade or business to calculate UBTI for each trade or business separately, rather than aggregating income from all unrelated trades or businesses. Under the proposed regulations, certain investment activities of exempt organizations are treated as unrelated trades or businesses for purposes of calculating UBTI. The proposed regulations also permit separate trades or businesses to be identified using the North American Industry Classification System (NAICS) codes (an industry classification system).

The proposed regulations also address:

Identifying and reporting an entity's investment activities, which are treated as a separate unrelated trade or business.
Treatment of partnership interests and payments received from controlled entities.
S-corporation interests and employee stock ownership plans (ESOPs) (see Practice Note, Employee Stock Ownership Plans (ESOPs)).

Methods for SUBs for Determining UBTI

Under the proposed regulations, SUB trusts generally use the same methods as other types of organizations to determine if they have more than one unrelated trade or business.

SUBs generally must include interest, dividends, royalties, rents, and capital gains in UBTI, unless these amounts are exempt function income (for example, income for paying life, sick, or accident insurance or other benefits). The exempt function income amounts are subject to statutory limits. Amounts categorized as exempt function income are excluded from UBTI, if the amounts actually are used to pay benefits. If not used for that purpose, the amounts are UBTI.

SUBs also treat certain investment activities listed under the proposed regulations (for example, qualifying S-corporation interests) as a separate unrelated trade or business for purposes of the TCJA requirements under Code Section 512(a)(6).

Supplemental Unemployment Benefit (SUB) Plans and COVID-19 | Practical Law